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Why Not Wait Until It All Calms Down?

Inflation, rising interest rates, and one of the worst geopolitical crises since World War II has created a perfect storm for volatility in the stock market. Is there some merit to getting out now and waiting for the volatility to subside?

Warren Buffett famously said to “be fearful when others are greedy.” His point was that greed and euphoria tend to inflate asset prices to the point where there’s little left to push them higher. The chart below shows that the opposite – be greedy when others are fearful - should be just as proverbial1.

The blue region depicts the return for an “opportunistic” investor who invested $10,000 into the S&P 500 at the start of 1980 and added $2,000 every time the market dropped 8% or more in a month (yellow dot). Such a strategy propelled a $42,000 investment to over $2 million.

The gray region indicates the return from a strategy where an “apprehensive” investor sold $2,000 each time the index dropped 8% in a month (red dot) and moved to cash. This strategy returned just over $600,000 over the same period, which is about half of what a basic “buy-and-hold” approach would have generated.

The difference in total return is so massive because of one of the most basic, yet paradoxical concepts in investing. The greater the perceived risk, the higher the expected return.

Apprehensive investors who ran to cash and waited for “things to cool down” sold to the opportunistic investors who were eventually compensated for buying that risk. But that’s not to say being an opportunistic investor is easy. Achieving such stellar results required buyers to:

1.      Be mechanical. They had to remove all emotion and be willing to buy each time a yellow dot appeared.

2.      Go against their gut. Survival instincts protect us from perceived danger, so buying into panic can be difficult.

3.      Remain disciplined. There have only been 16 yellow dots over the last 40+ years, so they had to be incredibly patient and stick to the strategy.

These are no small hurdles. For example, the yellow dots centered around 2008 indicate that buyers would have had to invest five times within a span of a few months. Think back to the days of the financial crisis, and then imagine the fortitude required to keep buying when it seemed as if the world was ending.

Simply put, opportunistic investors did better because they bought into panic rather than sold. But just as important, they became comfortable with uncomfortable investments or worked with an advisor who did it for them.

The bottom line

I’ve shown some variant of this chart over the years to investors of all shapes and sizes, and the most common pushback I hear is that it is unrealistic. Who in their right mind would mechanically buy every time the market dipped 8% in a month?

My response is that I agree that this simulation is unrealistic, but not because of the buying. Professional investors make their living from preying on the fear and panic of others, so the buy side is pretty much on point. What’s unrealistic to me is the sell-side because it’s unlikely that an apprehensive investor would only sell $2,000 during extreme panic. In my experience, apprehensive investors sell it all, and if so, just imagine how much worse their returns would have been over time.

Because stocks go down in elevators and up in escalators. The nature of the recovery makes it almost impossible to know when to get back in. They tend to be two steps forward, one step back. Three steps forward, four steps back. Two steps forward, one back. Five steps forward, two steps back, etc.

Hence, most don’t see the recovery until it’s recovered. Then, those who missed it will become psychologically anchored on some lower price when they wanted to buy but didn’t because they felt another move downward was imminent.

Lately, I’ve been hearing another pushback when trying to convince an investor to becoming opportunistic, and that is “this time feels different.” And you know what? They’re right!

Back in the day, apprehensive investors could cash out of stocks and still earn an ok return in money market funds. Today, that option isn't an option. Cash is losing money safely to inflation, which for retirees could be way higher than the 7.5% figure being reported by the government.

It's uncomfortable to think that a key tenet to owning stocks right now is a lack of options. But it’s still a compelling one for an opportunistic investor who recognizes that this market volatility is masking robust economic data and corporate earnings. Narrow it down to stocks of companies that can raise prices consistently and not see business walk out the door, and it’s hard to see what else matters right now.

Now, will being opportunistic protect against the volatility we’ve experienced so far this year? Probably not because emotional selloffs and recoveries tend to have no logic behind them. For example, corporate earnings didn’t fuel the selloff, so why should they support the recovery? But when it comes to managing risk over a period of more than a few months, I’ll take this approach any day over market timing and/or locking in a near certain loss in cash.

The bottom line is that waiting for markets to calm down doesn’t work. When the risk is gone, so is the prospect for future return.

Sincerely,

Brian Malizia, President

Mike Sorrentino, CFA

 

Sources

1 https://www.hartfordfunds.com/practice-management/client-conversations/how-to-learn-to-worry-less-and-love-a-market-correction.html

 

Disclosures

This newsletter/commentary should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the authors as of the date of publication and are subject to change. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no guarantee that any investment plan or strategy will be successful.